7895 / Can the owner of leased equipment take depreciation deductions? How large may the first year deduction be?

In determining the income or loss from the activity, an owner of leased equipment placed in service after 1980 may deduct its cost over a period of years–generally three, five, or seven years depending on the kind of equipment. (See Q 7891 concerning the ownership of leased property.) For property placed in service after 1986, the amount of the deduction is generally determined by applying a declining balance method to the basis of the property¹ (see Q 716). Normally, the initial basis of the property is its cost. For property placed in service after 1981 and before 1987, the amount of the deduction was a percentage of the “unadjusted basis,” generally, the cost of the property.² (For property placed in service after 1986, the Service has published tables that were prepared using the appropriate declining balance method, but that provide percentage figures to be applied to the unadjusted basis of the property in determining each year’s cost recovery allowance.)³ For the temporary rules dealing with bonus depreciation and the rules in IRC Section 179 providing an election to expense a portion of the costs of acquiring equipment, see below.

Cost includes the principal amount of debt already encumbering the property or new debt incurred in acquiring the property, whether recourse or not.⁴ However, the debt must be bona fide; it is not included in basis if the purchase price substantially exceeds the fair market value of the property that nominally secures the liability.⁵ Basis for depreciation must be reduced by the portion of the basis that the taxpayer may have elected to treat as an expense (see below). The basis is further reduced by the basis adjustment attributable to the investment tax credit (see Q 7894). The basis for depreciation under the declining balance method is calculated each year as reduced by depreciation deductions allowable in previous years, while the unadjusted basis is generally determined in the first year that a property is placed in service and is not reduced by depreciation deductions.

Depreciation is limited in the year in which equipment is placed in service to the portion of the year in which the equipment is considered to be held under the following conventions. Equipment is generally treated as placed in service on the midpoint of the year in which placed in service. However, where 40 percent of depreciable property, other than residential rental property and nonresidential real property, is placed in service during the last three months of the year, equipment placed in service during any quarter of such year is treated as placed in service on the midpoint of such quarter. Property placed in service and disposed of in the same year is not taken into account under the 40 percent test and the mid-quarter convention.⁶ The IRS provided relief from the mid-quarter convention if a taxpayer’s third or fourth quarter included September 11, 2001.⁷

The mid-quarter 40 percent test is made without regard to the length of the taxable year. Thus, if property (with exceptions, as noted in the preceding paragraph) is placed in service in a taxable year of three months or less, the mid-quarter convention applies regardless of when the property was placed in service (i.e., 100 percent of property has been placed in service in the last three months).⁸

In the case of a short taxable year (i.e., a taxable year that is less than 12 months), the recovery allowance for equipment is determined by multiplying the deduction that would have been allowable if the recovery year were not a short taxable year by a fraction, the numerator of which equals the number of months in the short taxable year and the denominator of which is 12.⁹ Proposed regulations under IRC Section 168(f)(5) (as in effect prior to TRA ’86) provided that a taxable year of a person placing property in service did not include any month prior to the month in which the person began engaging in a trade or business or holding recovery property for the production of income.¹⁰ Presumably, this principle would continue to apply after TRA ’86.

A partner who purchases an interest in a partnership after it has commenced business can deduct depreciation attributable only to the period during which he or she owns the partnership interest.¹¹

In the first year of investment in a partnership, a partner’s depreciation deduction is generally prorated because of (1) the partnership’s short taxable year and (2) the rules applicable when a partner purchases an interest after the partnership commences business. As a result, an investor purchasing a partnership interest late in the year will find the first year depreciation deduction substantially limited.

The inability of a partner to take a full first year depreciation deduction if he or she invests late in the year has created considerable interest in forming equipment leasing programs as grantor trusts. Since for tax purposes the investor in a grantor trust is generally treated as the owner of the investor’s proportionate share of the property contained in the trust (under IRC Sections 671 through 679), it is reasoned that the taxable year of each investor is used to determine whether the investor can take a full year depreciation deduction on his or her proportionate share. The taxable year of the investor, for depreciation purposes, does not begin prior to the month the investor begins engaging in a trade or business or holding depreciable or recovery property for the production of income.¹² If the investor engages in such activities for the full year, he or she is entitled to a full first year depreciation deduction (subject to the conventions discussed above). Otherwise, the investor is limited by a short taxable year and corresponding proration of the first year depreciation deduction. However, if the investor engages in a small amount of such activities prior to investment in the program with the purpose of obtaining disproportionately large depreciation deductions, the investor’s taxable year (for purposes of the depreciation deduction) does not begin prior to investment in the program.¹³

S corporations are treated like partnerships for purposes of determining the first year depreciation deduction. The first year depreciation deduction is pro-rated over the year and the deduction is taken only for depreciation allocable to the part of the year the S corporation has been in business or that a shareholder owns his or her interest. Ownership through a co-tenancy or individual ownership is treated like a grantor trust for this purpose. A full first year depreciation deduction (subject to the conventions discussed above) is available to an investor who has throughout the year engaged in a trade or business or held depreciable or recovery property for the production of income.